What is Gratuity? Is Income Tax Exempted on Gratuity?

Income Tax Exempted on Gratuity

What is Gratuity?

A company pays gratuity as a lump sum when an employee leaves the organization, making it one of the company’s retirement benefits. In India, the Payment of Gratuity Act 1972, which establishes the rules and requirements for gratuity, also offers income tax exemption on gratuity. Employers can also opt to provide compensation beyond what this Act mandates.

Income Tax Exemption on Gratuity:

Gratuity may be one of the components of your CTC. The Income Tax Act taxes it under “Income from Salaries”. Now, let’s examine how to calculate the exemption for a portion of received gratuity by Section 10(10) of the Income Tax Act.

The Payment of Gratuity Act 1972 sets out the rules that apply to an employer regarding gratuity.

When is Gratuity Payable as per Payment of Gratuity Act 1972:

Gratuity is payable to an employee when an employee leaves employment after completing at least five years in service with an employer – so this is payable –

  • On superannuation (means an employee who attains the age of retirement is said to be in superannuation)
  • On retirement or resignation
  • On death or disablement due to accident or disease (the time limit of 5 years shall not apply in the case of death or disablement of the employee)

Note that your regular monthly salary does not encompass Gratuity; instead, we provide it only when any of the situations above occur.

Gratuity Applicability as per Payment of Gratuity Act 1972:

Any person employed in a factory, mine, oil field, port, railways, plantation, Shops, establishments, or educational institution with 10 or more employees during any day in the preceding 12 months is eligible for Gratuity. It is applicable only to permanent employees and not to trainees/interns.

Once the Act becomes applicable to an employer – even if the number of employees goes below 10, gratuity is still applicable.

Income Tax Exemption on Gratuity payment to an employee as per Income Tax Act:

In the case of Gratuity received by a Government Employee

Any gratuity received by an employee of the Central Government, State Government, or local authority, on death or retirement is fully exempt from tax.

In case of Gratuity received by an employee where the Employer is covered by the Payment of Gratuity Act.

The least of the following is exempt from Tax

  • 15 days’ salary based on the salary last drawn for every completed year of service or part thereof in excess of 6 months. Therefore, calculate the exempted amount from the total Gratuity paid as follows: last drawn salary multiplied by the number of years in employment, all multiplied by 15/26.

The last drawn salary is the Basic salary and DA. Round off the number of years in service to the nearest whole year. For instance, if you have worked in an organization for 12 years and 2 months, consider the number of years in employment as 12. Similarly, if you have worked for 12 years and 7 months, view the number of years in the profession as 13.

  • Rs 10,00,000
    Gratuity actually received

Let’s understand this by way of an example – Rahul worked for a company for 18 years and 7 months. His company is covered by the Payment of Gratuity Act. At the time of his retirement, his salary was Rs 20,000. He received Rs 8,00,000 as Gratuity from his employer.

Calculation of amount which is exempt from Rs 8,00,000 – lower of the following 3

  • 20000 x 19 x 15/26 = Rs 2,19,230
  • Rs 10,00,000
  • Rs 8,00,000

The amount that is exempt from Gratuity payment for Rahul is Rs 2,19,230 and the remaining amount of Rs 8,00,000 – Rs 2,19,230 = 5,80,769 is taxable for Rahul.

In case of Gratuity received by an employee where the Employer is not covered by the Payment of Gratuity Act

The least of the following is exempt from Tax

  • Half a month’s salary for each completed year of service. When calculating completed years, we disregard any fraction of a year. For instance, if you’ve been with an organization for 14 years and 9 months, we consider the number of years in employment as 14 years. In this calculation, we take the salary as an average of the 10 months immediately preceding the retirement month.
  • Rs 10,00,000 Gratuity actually received

For example – Sunil who works for XYZ Ltd. Retires after 30 years and 9 months of service. He receives Rs 8,00,000 as a gratuity. His average monthly salary for 10 months immediately preceding the month of retirement is Rs 50,000.

For Sunil, the minimum of these amounts shall be exempt from Tax

  • 50,000 x ½ x 30 = 7,50,000
  • 10,00,000
  • 11,00,000

Therefore for Sunil Rs 7,50,000 shall be exempt from Tax and he will pay tax on Rs 8,00,000 – 7,50,000 = Rs 50,000. Rs 50,000 shall be taxed and included under the head ‘Income from Salaries’.

Few Notable Points:

Suppose the employer chooses to pay a Gratuity exceeding Rs 10,00,000. In such a scenario, we will calculate the exemption using the same method as previously explained.

If the employee’s services have been terminated due to any misconduct, the employer has the right to reject payment of Gratuity to the employee.

If the employee passes away, either the nominee or the legal heir of the employee can receive the Gratuity. In this scenario, we calculate the exemption using the same method described earlier, and the receiver is subject to taxation under the ‘Income from other sources’ category.

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